Encyclopedia

Commercial Real Estate, Income Property, and Real Estate Investment

(Terms, Concepts, Principles, Practices, Mathematical Explanations)

The Encyclopedia below is part of RealBenefits Real Estate Investment and Development Software suite. The Encyclopedia contents have been copy-pasted below and are provided to you for free. If you'd like a full color version of the Encyclopedia, you can download it free as part of the free trial version of RealBenefits Real Estate Investment and Development Software suite. The full color encyclopedia version has words color coded for meaning, which makes it much easier to read and understand the encyclopedia. If you download the free trial software to get the color version of the Encyclopedia, be aware that the free trial software works 10 times for financial calculations, but its Encyclopedia works forever.

Introduction to Encyclopedia

Encyclopedia Copyrighted 1995 to Present Day - RealBenefits, LLC.

Author: Charles Bond Jr. in cooperation with many real estate and accounting professionals. For a list of coauthors, see About Us.

The “Benefits of Income Property Ownership” software is usually referred to as "Benefits IPO" or "Benefits Workbook" for short.

The “Benefits IPO" software’s purpose (see its “Total Benefits” sheet) is as follows: It uses Standard Real Estate Practices to analyze income property as far as this approach allows (Cap Rate, GRM, Debt Coverage Ratios, Cash Flow, and Amortization), and then expands the analysis using accounting principles to analyze the benefits of income property ownership like an annuity. The investment (down + closing costs + loan points + any repairs made at or near closing) is the value outflow at the beginning of the first year. Each year’s “Annual Benefits Total” is the value inflow occurring at the end of that year (in reality many of the benefits occur monthly, but are calculated as if all benefits occurred at the end of each year). The 10th year’s “Annual Benefits Total” is another value outflow due to capital gains tax at the time of sale (projections assume a sale at the end of the 10th year). The IRR and NPV of the value inflows and outflows are then calculated and stated as the IRR and the NPV FBO (Net Present Value of the future Financial Benefits of Ownership) of the subject property if purchased by the specific investor being analyzed. This answers an investor's (buyer's) question: "How can purchasing this income property financially benefit me?". It also helps agents, CPAs, lenders, and sellers answer that question for a buyer. Additionally, the software can be used to help sellers determine their financial benefits of keeping the income property versus selling it (see Return on Equity). Lease vs. Buy analyses can also be made.

Since you are a real estate professional, lender, or CPA, you are already familiar with many of the terms and concepts. However, it is prudent to address the terms and concepts in relation to the software. Also, real estate terminology differs across the USA and between the different professions (real estate sales, development, appraisal, lending, etc.). Additionally, the same financial indicator term(s) may be calculated in a variety of ways according to the geographical area and/or profession. This encyclopedia addresses these issues in-depth.

Standard Real Estate Practices (SREP) (used by lenders, agents, appraisers, developers, professional R.E. investors) differ from Generally Accepted Accounting Principles (GAAP) with regard to "Net Operating Income" and "Net Income" calculations. SREP uses these terms interchangeably and calculates them WITHOUT deducting Depreciation or Interest Expense from the Adjusted (Effective) Gross Income. The Benefits IPO software adheres to both SREP and GAAP, except with regard to: ''Net Operating Income'' and ''Net Income'' calculations, which are calculated according to the context of the topic, and IRR and NPV FBO (Net Present Value of the future Financial Benefits of Ownership), which are calculated (like an annuity) according to GAAP. To reduce confusion, the "Net Operating Income" and "Net Income" dollar amounts are NOT shown in the Benefits IPO software. However, they are used to explain certain topics and to calculate Debt Coverage Ratios (DCR) and Cap Rates (OARs).

This encyclopedia is of great importance to you because it not only defines terms, but also explains how they are calculated and how they relate to various professions in various regions. A few terms are unique to the software because there were no existing terms for certain in-depth things the software addresses. The software analyzes real estate income property at a more in-depth level than standard real estate or accounting terminology can fully cover.

The terms are not in alphabetical order, but instead are in an order that allows a logical progression of thought (i.e.- in the order that allows each concept to build on prior concepts). Since all of you who are using the software are professionals, you will have your own opinions. Because you are a professional, you are qualified to make your own decisions about terms, how to use the software, and if input and output numbers are realistic. In fact, these decisions are your responsibility. The investor should consult a CPA.

Thank you, Chuck Bond Jr. (RealBenefits founder and main creator) and Bill Behrens (RealBenefits owner). About Us - our qualifications, how and why the encyclopedia and software were developed, how long we've been in business, etc. Note: there are also many coauthors of this encyclopedia and software listed in the About Us area. Some parts of this encyclopedia were written by Charles Bond Jr. and then edited by one or more coauthors. Other parts were written by one or more coauthors and then edited by Charles Bond Jr. It was a team effort.

Beginning of Encyclopedia

APOD (Annual Property Operating Data)
This is an operating statement for an income producing property. The APOD follows standard real estate practice, NOT standard accounting practice when calculating Net Operating Income. That means that Depreciation Expense should NOT be deducted from Adjusted Gross Income when calculating Net Operating Income. Therefore, DO NOT enter Depreciation Expense in the Operating Expenses. Cap Rate calculations depend on this.

Investment (also see the "Annuity" and "Annuity Value" sections below)
It is very important that you read this. Normally, the definition of the word "Investment" varies according to context. However, in this software it is always defined the same way and all calculations are based on that definition. The definition is extremely important mathematically with regard to the calculation of Returns, IRR, and NPV FBO.
Some background information and a detailed explanation follow.

In the context of real estate in general, the term "Investment" can mean the property itself, or the money (value outflow) needed to purchase the property. In the context of this software, the term "Investment" always means the value outflow (usually money) needed to purchase the property, but this needs further definition.

In Standard Real Estate Practice (SREP), when using the term Investment to mean the value outflow (usually money) needed to purchase the property, this means the Downpayment. Therefore, in SREP the Downpayment is considered to be the Investment (i.e.- value outflow to purchase the property) and is used in the Returns and IRR calculations. This is NOT an accurate way to calculate Returns or IRR because the true Investment is the Downpayment + Closing Costs + Exceptional Closing Costs + Loan Points. In other words, the true Investment is the total value outflow (usually money) paid by the Buyer to purchase the property. The Downpayment is only a portion of the true Investment.

According to Generally Accepted Accounting Principles (GAAP): When analyzing an Annuity, the total value outflow needed to purchase the Annuity is used as the initial value outflow at the beginning of the first period in the Return, IRR, and NPV calculations. In this software the 1st year is the first period.

This software analyzes income property like an Annuity. The Investment (i.e.- value outflow) needed to purchase the property (i.e.- annuity) is the total value outflow (usually money) needed to purchase the property. Therefore, the Investment = Downpayment + Closing Costs + Exceptional Closing Costs + Loan Points.
In other words, the Investment is the total value outflow (usually money) paid by the Buyer to purchase the property.

Therefore, in the context of this software the term Investment is mathematically defined as follows:
Investment = Downpayment + Closing Costs + Exceptional Closing Costs + Loan Points.
In this software, the term Investment means the total value outflow (usually money) paid by the Buyer to purchase the property. This allows this software to make the most accurate calculations possible for Returns, IRR, PV FBO, and NPV FBO. These calculations are made according to Generally Accepted Accounting Principles.

Note: Exceptional Closing Costs are anything other than the Downpayment, Closing Costs, or Loan Points that the Buyer (i.e.- investor) must pay for before closing, at closing, or within one year of closing. Typically, an Exceptional Closing Cost is a much needed repair, such as a new roof or carpet, but can be anything.

Annuity (how income property is analyzed like an annuity)
An annuity is an investment which requires an initial "value outflow(s)" (usually cash, but not always) from the investor, and later gives the investor periodic "value inflow(s)", and possibly future periodic "value outflow(s)" as well. The IRR, PV, and NPV of the "value inflow(s)" and value "outflow(s)" can be calculated using time value of money principles.

In this software, the initial value outflow (at the beginning of the 1st year) is the Investment the buyer makes to acquire the property. This is the Downpayment + Closing Costs + Loan Points + Exceptional Closing Costs. Repairs made at or near closing are called "Exceptional Closing Costs" and are entered in the "Exceptional Closing Costs" grey data input cell on the "Form" sheet. Examples of two common Exceptional Closing Costs are replacing the roof and/or carpet before, at, or soon after closing. Exceptional Closing Costs are by definition paid by the Buyer. If the Seller pays for a repair it is not an Exceptional Closing Cost because it does not count as part of the Buyer's Investment (i.e.- value outflow) to acquire the property.

In this software, the value inflows are the "Annual Benefits Totals" for years 1 - 9 which are comprised of Cash Flow, Appreciation, Loan Reduction, and Tax Benefits (see the "Total Benefits" sheet) and are treated as occurring at the end of each year even though some of these benefits occur monthly. The "Annual Benefits Totals" column shows each year's financial benefits of ownership. The 10th year’s “Annual Benefits Total” is a value outflow due to Capital Gains Tax at the time of sale (projections assume a sale at the end of the 10th year). The IRR and NPV of the value inflows and outflows are then calculated and stated as the IRR and the NPV FBO (financial benefits ownership) of the income property if purchased by the specific investor being analyzed.

The "Annuity Approach" used by this software to analyze income property is not common to the real estate industry and is not based on Standard Real Estate Practices. It is an accounting based approach. This software does all the usual Standard Real Estate Practices (SREP) analyses and then expands them using Generally Accepted Accounting Principles (GAAP) to analyze the investment property as if it were an annuity. This only works with income properties and cannot be used with non-income producing properties. Any physical property type of real estate can be analyzed as an income property if the owner or prospective owner receives, is projected to receive, or could receive an income as a result of owning the property. The income is usually the result of renting or leasing the property, but other income producing possibilities may exist.

Annuity Value (also see "Annuity" above, "Value" below, and "NPV FBO" far below)
"Annuity Value" is the value of the investor's projected Financial Benefits of Ownership (i.e.- value outflows and inflows over time). "Annuity Value", "Personal Value", and "the value of the investor's projected financial benefits of ownership" are all synonymous. The "Annuity Value" must be determined by the investor's CPA. It can be the PV FBO (Present Value of the Financial Benefits of Ownership), NPV FBO (Net Present Value of the Financial Benefits of Ownership), or it whatever the investor's CPA decides.

See the "Annuity" section above and the "Personal Value" and "Value" sections below for more information. "Annuity Value" is NOT the same thing as Property Value.

Personal Value (also see "Annuity Value" above, "Value" below, and "NPV FBO" far below)
In this software, the term "Personal Value" is synonymous with "Annuity Value". The term "Annuity Value" is sometimes referred to as "Personal Value" because this type of value is based on the investor's personal data (as well as the property data), and is therefore unique to that investor. The "Personal Value" must be determined by the investor's CPA.

See the "Annuity" and "Annuity Value" sections above and the "Value" section below for more information. "Personal Value" is NOT the same thing as Property Value.

Property Value
The term "Property Value" is self-explanatory. Property Value is NOT the same thing as "Annuity Value", "Personal Value", or the "value of the investor's projected financial benefits of ownership". See the "Value" section below for more information.

Note: The NPV FBO is not the Net Present Value of the income property. The NPV FBO is the Net Present Value of the specific investor's projected future Financial Benefits of Ownership. NPV FBO is the PV FBO less the Investment of Downpayment + Closing Costs + Exceptional Closing Costs + Loan Points.

Value (also see the other value topics above)
There are two separate value issues: Property Value, and the value of the financial benefits of ownership. The value of the financial benefits of ownership is also called "Annuity Value" (see the "Annuity" topic above). The value of the financial benefits of ownership is also called "Personal Value" because it is the value of the specific investor's projected financial benefits of ownership based on the property data and that investor's personal data. Therefore, "Annuity Value", "Personal Value", and "the value of the investor's projected financial benefits of ownership" are all synonymous.

Regardless of the type of value you are attempting to address, you should make at least two analyses. One based on the current gross income, vacancy factor, and expenses, and another based on what they should be under new management. This is because the quality of the management has such a large impact on these factors, and the management usually changes when the property ownership changes.

In accordance with Standard Real Estate Practices, you can compare the Cap Rate and GRM (Gross Rent Multiplier) of the subject property to the Cap Rates and GRMs of comparable properties to arrive at an estimate of Property Value. However, Cap Rates are often inaccurate because landlords (i.e.– sellers) often misstate the expenses and/or vacancy factor (which is why GRM is sometimes used). Also, Cap Rate and GRM do not take into account the available financing terms, which may be different for each property (such as contract terms). Financing terms can substantially affect the investment. The attributes of the Cap Rate and GRM are that they are easy and convenient to calculate and are stated in almost all income property listings’ data.

By comparing the subject property’s Cap Rate and GRM to those of comparable properties, the Property Value can be estimated. However, Cap Rate and GRM do not take into account the property condition and therefore, can only be used to compare properties of similar condition. Cap Rate and GRM are based on the 1st year only, and therefore, even with a property inspection they ignore repairs which would be needed after the 1st year. Cap Rate also ignores several important financial issues: Interest Deductions, Depreciation Deductions, Appreciation, and the time value of money. GRM ignores even more issues than Cap Rate does.

Cap Rate, GRM, and Property Value are topics that agents, appraisers, and professional investors already address. To address these topics, a physical property inspection and access to a current comparable property database are needed. Agents typically address these topics for free (CMAs), and appraisers address these topics if an appraisal is done. Therefore, the Cap Rate, GRM, and Property Value are issues that have probably been addressed before the investor goes to a CPA for advice. The investor can probably get Cap Rate, GRM, and Property Value issues addressed most economically by a real estate professional. Therefore, RealBenefits recommends leaving the Property Value topic to agents, appraisers, and professional investors, rather than a CPA, but a CPA is still needed for advice on other topics described below.

Ultimately, agents, appraisers, and investors must make an educated guess about Property Value. In a market economy, the true Property Value is whatever the highest bidder is willing to pay for the property, but this isn’t known until after a sale closes. Therefore, Cap Rate is as close as the “Benefits IPO” software comes to addressing Market Value. It does not explicitly state the Market Value for the reasons described above.

What the investor (buyer) cannot get from the real estate community are the things they need most from a CPA. Standard Real Estate Practices, and therefore the real estate community, traditionally ignore several financial benefits of ownership when making analyses: Interest Write-offs, Depreciation Write-offs, Appreciation, how financing affects the investment, and the time value of money. Also, the real estate community traditionally ignores many issues related to things that occur after the first year. This “Benefits IPO” software uses accounting principles to address these issues by analyzing all the financial benefits of ownership for years 1–10 as if the income property were an annuity. The IRR and NPV of the Financial Benefits of Ownership (NPV FBO) are stated and can be thought of as the IRR and NPV of the “annuity”. The investor cannot get assistance in these areas from the real estate community (unless they're using this software). Also, although many real estate investors understand the real estate principles involved, few understand the accounting principles involved. Therefore, the investor needs a CPA’s assistance to address all of the issues mentioned in this paragraph.

The investor especially needs a CPA’s help in determining the "value of the investor’s projected financial benefits of ownership" (aka "Personal Value", aka "Annuity Value"). Although the “Benefits IPO” software states the IRR and NPV FBO, it does not explicitly state the value of the projected financial benefits of ownership. Stating the value of the projected financial benefits of ownership is beyond the scope of this software and is something that the investor needs their CPA’s help with. The projections made by this software are tools to assist CPAs in making value decisions. PV FBO and NPV FBO are possible "Annuity Values", but "Annuity Value" is not explicitly stated because the investor's CPA must determine it.

Repairs & Improvements (R & I) - See the bottom of the "Instruc. Basic & Advanced" sheet for an explanation/definition of this topic and for instructions on how, why, and when to enter R & I input data into the "Form" sheet.

Comparables (aka Comparable Properties) Also see the "Instruc. Basic & Advanced" sheet for how to enter "Comparables" data into the "Form" sheet.

Comparables are similar properties in a similar location which are for sale, or have recently been sold, or have a sale pending on them.

Also, in the case of income properties, a comparable is any similar property which may be used for comparing income, expenses, vacancy factor, and other operational details, regardless of whether the property is for sale or has ever been sold.

Often you will want to compare properties as potential investments. When comparing properties, you can only compare properties of like type and condition, and then only if the numbers are correctly calculated using the same methods. If you do all the calculations yourself by using this software, you can assure yourself that the numbers were calculated using the same methods on all properties which means you are comparing apples to apples, so long as the properties are of like type & condition and the input numbers are accurate.

If you cannot find a property that is exactly alike, you will have to find as similar a property as possible and then make adjustments to the lesser property to bring it up to (hypothetical) equality with the better property. Then you can make comparisons. The more alike the properties are to begin with, the less you will have to adjust, and the more accurate the comparison.

Instructions on how to use this software with comparables are in the "Instruc. Basic & Advanced" sheet in the "Advanced Instructions" section.

Adjustments (in regard to comparables and market analysis) (also see comparables above)
See the bottom of the "Instruc. Basic & Advanced" sheet for an explanation/definition of this topic and for instructions on how to enter adjusted input data into the "Form" sheet.

Historically Based Input Amounts
Input amounts based on the historical (i.e. - past and/or current) performance of the subject property, such as Contract Rents, Historical Expenses, Historical Vacancy Factor, etc.

Market Based Input Amounts
Input amounts based on the performance of comparable properties, such as the Market Rent, Market Expenses, Market Appreciation, Market Vacancy Factor, etc.

Contract Rent - what the income actually is for the subject property.

Historical Expenses - the actual past Expenses of the subject property.

Historical Vacancy Factor - the actual past Vacancy Factor of the subject property.

Market Rent - the income amount that it seems reasonable that the subject property should have based on the rents of comparable properties. See the above "Market", "Historical", and "Contract" items.

Market Vacancy Factor - the Vacancy Factor that it seems reasonable that the subject property should have based on the Vacancy Factors of comparable properties. See above "Market", "Historical", & "Contract" items.

Market Expenses - the expense amount that it seems reasonable that the subject property should have based on the expenses of comparable properties. See the above "Market", "Historical", and "Contract" items.

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WARNING -- If you are getting input numbers that represent "historical numbers" from someone else, such as a seller, you should verify those input numbers yourself. For example, if the seller tells you the electricity runs $X per month, you should call the electric company and ask them, or ask the seller for receipts. My point is that you have to get good input numbers before you start entering numbers into the software, and you need to verify those numbers yourself and not take someone else's word for it.

This warning applies when you are making projections based on the Contract Rent(s) (actual rents), Historical Vacancy Factor, Historical Expenses, etc. Projections based on these amounts will tend to show how the property would perform over the next 10 years if under the SAME MANAGEMENT as before the investor purchases the property. However, if the property were mismanaged, its historical performance would not be a good indicator of how it would perform under new management. If the new management were more competent than the old, then the property's future investment performance would more closely resemble the performance of comparable properties. Remember, historical performance indicates how the property has done under past management, not how it will do under future management.

To see the potential the property has under new management, look at the performance of comparable properties. This will also help you see if the past management's historical performance is up to par. If done properly, this can help you arrive at the most reasonable input numbers, which will give the most reasonable projections.

In addition to a presentation of projections based on historical numbers, it is also advisable to make a presentation of projections based on the Market Rents, Market Expenses, and other "market amounts". This means rents, expenses, appreciation, etc., according to what comparable properties show as reasonable. This is a "market based" presentation.

Typically the investor should be given (at least) two presentations of projections, one with input numbers based on the historical performance of the subject property, and another with input numbers based on market values (i.e. - what the rents, vacancy factor, and expenses should be based on comparable properties). The investor should be clearly informed which presentation is which, and what the input numbers are based on.
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Net Operating Income (see Net Income below)

Net Income (as calculated by real estate vs. accounting practices)
Real estate practice is to use the terms Net Income and Net Operating Income interchangeably because in real estate practice they are synonymous. In real estate practice the Operating Expenses are deducted from the Adjusted (Effective) Gross Income to arrive at the "Net Income" aka "Net Op Income". Depreciation and Interest Expense ARE NOT deducted from the Adjusted (Effective) Gross Income.

In accounting practices, the terms Net Operating Income and Net Income are two different things. Net Operating Income is calculated by deducting Operating Expenses, including Depreciation, from the Adjusted (Effective) Gross Income (Interest is not deducted). Net Income is calculated by deducting all expenses, including Depreciation and Interest.

This software intentionally avoids stating the dollars of Net Operating Income or Net Income anywhere. This is to avoid confusion because these terms mean different things in real estate vs. accounting practices. However, the terms "Net Income" and "Net Operating Income" are used to explain several concepts. Therefore, always read the notes to see which "Net Income" or "Net Op. Income" is being referred to (i.e.- real estate or accounting).

OAR (aka Overall Rate of Return) - see Cap Rate below

Cap Rate aka Overall Rate of Return (OAR) is based on the 1st year only (actually the first month X 12).

A higher Cap Rate (OAR) suggests a better Property Price to Net Income relationship. Therefore, a higher Cap Rate is better than a lower Cap Rate if the properties are in like (equal) physical condition. They are rarely in equal condition, which is why Property Price adjustments should usually be made before calculating Cap Rate (OAR). Many other factors besides Cap Rate (OAR) should be taken into consideration when evaluating an income property.

There are different ways to calculate Cap Rate according to what part of the USA you are in.
The software uses the method that is the most common.

Standard Real Estate Practices (SREP) (used by lenders, agents, appraisers, developers, etc.) differ from Generally Accepted Accounting Principles (GAAP) with regard to "Net Operating Income" and "Net Income" calculations. SREP uses these terms interchangeably and calculates them WITHOUT deducting Depreciation or Interest expense from the Adjusted (Effective) Gross Income. This software adheres to both SREP and GAAP, except with regard to ''Net Operating Income'' and ''Net Income'' calculations, which are calculated according to the context of the topic. To reduce confusion, neither dollars of "Net Operating Income" or "Net Income" are shown anywhere in this software; however, the SREP calculated NOI and NI are used to calculate Debt Coverage Ratios (DCR) and Cap Rate (OAR).

Cap Rate is Year 1 Net Income divided by Purchase Price.

Net Income here means as calculated by real estate practices. Depreciation and Interest are not deducted from the Adjusted (Effective) Gross Income when calculating the Net Income.

Net Income is arrived at by deducting the Vacancy Factor, Expenses, and Management Fee from the Scheduled Gross Income. Net Income is always a projection, even on buildings with an operating history, because the Net Income and Expenses used are the projected 1st year (into the future) Net Income based on taking the monthly figures at the time of the property purchase (or hypothetical purchase) and multiplying by 12 to get an annual number. Cap Rate does not take into account anything beyond the 1st year, and in the 1st year does not consider Depreciation (related Tax Benefits), Appreciation, or Interest write-offs. Cap Rate is a convenient, but very superficial way to evaluate an income property.

Cap Rate is commonly used by investors and agents because it is simple and convenient to calculate, and because it is stated in most income property listings which allows convenient comparisons of comparable properties. IRR is a much better indicator, but is more difficult to calculate (without software), and requires more input data, and therefore more research. Also, Cap Rate is in regard to the property, regardless of who the investor will be. IRR is based on a combination of the property data and the investor's personal data (financing terms, Tax Bracket, etc.). Therefore, Cap Rate is a good way to make a superficial analysis of large numbers of comparable properties, especially if you do not know who the investor will be, but IRR is a good way to make an in-depth analysis when the choices have been narrowed down to only a few properties, and it is known who the prospective investor (buyer) is, and what their personal data is (financing terms they can get, Tax Bracket, etc.).

Cap Rate is a projected number used to compare income properties for sale when it is not known who the investor (i.e.- buyer) will be. To be a valid comparison the properties have to be like properties in like condition, and the Cap Rates have to be correctly calculated using the same calculation method. Even if all these things happen, the Cap Rate is static because it doesn't consider Appreciation, Depreciation, time value of money, or other time issues. Cap Rates also don't consider the effect that financing has on properties. Cap Rate is lacking in information compared to IRR, but Cap Rate has the following advantages: it is simple to calculate, only requires property data (not investor data which may not be available), and is stated in almost all income property listings nationwide (IRR is rarely stated, but if stated is usually an incorrect figure anyway).

Gross Income Multiplier (GIM) - see Gross Rent Multiplier (GRM) below:

Gross Rent Multiplier (GRM)
A lower GRM suggests a better Property Price to Income relationship. Therefore, a lower GRM is better than a higher GRM if the properties are in like (equal) physical condition. They are rarely in equal condition, which is why Property Price adjustments should usually be made before calculating GRM. Many other factors besides GRM should be taken into consideration when evaluating an income property.

GRM is commonly used because it is convenient to calculate with a hand calculator, NOT because it is a good or reliable financial indicator. GRM is not very informative, but you need to understand GRM anyway because it is commonly used and stated in listings. Understanding GRM is not as simple as you might think (see below).

There are 4 different methods for calculating GRM. Also, GRM is sometimes called "Gross Income Multiplier" (GIM). The calculation method and name depend on where in the USA you are located.
In this software, the name "Gross Rent Multiplier" (GRM) is consistently used.

As for calculating the GRM, in some parts of the country the "Adjusted Gross Income" (AGI) aka "Effective Gross Income" (EGI) is used for the calculation; while in other areas the "Scheduled Gross Income" (SGI) aka "Potential Gross Income" (PGI) is used.

This software always uses "Scheduled Gross Income" (SGI) in calculations because that is most common.

Property Purchase Price divided by SGI = GRM (a lower GRM is better than a higher one)

In some parts of the country Monthly SGI is used, while in other areas Annual SGI is used. This software calculates it both ways, so that you get a "Monthly GRM" and an "Annual GRM".

In some regional areas the monthly figure is called GIM and annual figure is called GRM, and in other regions the reverse is true. To resolve this regional terminology conflict, this software ONLY uses the term GRM and does NOT use the term GIM. In this software there is a "Monthly GRM" and an "Annual GRM".

To manually calculate the Annual GRM, take the Purchase Price and divide the Annual Scheduled Gross Income into it. First calculate the Gross Rent by taking the monthly Gross Rent at the time of purchase and multiply by 12 (hence Annual GRM is indirectly based on the first month). Since there is no appreciation figured into this, and there will likely be appreciation, that means the GRM number is conservative, but that is how it's done. This is for quick comparisons to the GRMs of other properties. An Annual GRM of 8 means the price is 8 times larger then the Annual Gross Income. If one property is an 8 and another a 9, then the 9 costs more in relation to the Scheduled Gross Income.

GRM does not tell anything about property condition, expenses, appreciation, depreciation, or a lot of other things, but is fast and convenient to figure out, however it only is useful for like properties in "like condition". GRMs do not consider the effects of time, expenses, or financing, so GRMs are not very informative, but they are at least more likely to be truthful than Cap Rates because a seller cannot misrepresent his monthly Scheduled Gross Income without a high likelihood of being caught.

With Cap Rates a seller could misrepresent expenses and vacancy factor, and thereby alter the Cap Rate to look falsely good. This is not as easy to verify as is Gross Rent and Sales Price which are all that is needed to verify a GRM.

Both Cap Rates and GRM are supposed to be quick, easy comparisons of investment properties, however the Cap Rate is too subject to misrepresentation to be taken seriously, unless you carefully investigate the expenses and vacancy factor which is not something you have time for if you are making quick and easy comparisons of many properties. Therefore GRM is usually better for quick and dirty comparisons. For an in-depth comparison, look at cash flow, return, and especially at Internal Rate of Return (IRR). Of course you will want to verify the income, expenses, vacancy factor for the local area, prior history of appreciation in that locale, etc. The point is that it's worth investigating the input numbers for the information you get from the returns, internal rate of return, and cash flow. It is not worth the effort in my opinion to go to that investigative trouble to check out a Cap Rate when the Cap Rate doesn't tell you much anyway. GRM doesn't tell much either, but at least it's generally accurate because it cannot easily be misrepresented, and it's fast to calculate as well.

Debt Service Ratio (DSR) - same as Debt Coverage Ratio (DCR)

Debt Coverage Ratio (DCR) aka Debt Service Ratio, aka Debt Service Coverage Ratio

This software calculates Debt Coverage Ratio (DCR) based only on income, expenses, and payments associated with the investor's interest in the subject property.

DCR can also be calculated based on the investor's total personal income and financial obligations, including those associated with the subject property. However that is beyond the scope of this software.

There is a different Debt Coverage Ratio for each year of ownership based on that year. The lender is primarily concerned with the Debt Coverage Ratio for year one.

Also, if there is more than one loan, there is a DCR for each loan according to its position, and there is a DCR for the total of all loans.

Standard Real Estate Practices (SREP) (used by lenders, agents, appraisers, developers, etc.) differ from Generally Accepted Accounting Principles (GAAP) with regard to "Net Operating Income" and "Net Income" calculations. SREP uses these terms interchangeably and calculates them WITHOUT deducting Depreciation or Interest expense from the Adjusted (Effective) Gross Income. This software adheres to both SREP and GAAP, except with regard to ''Net Operating Income'' and ''Net Income'' calculations, which are calculated according to the context of the topic. To reduce confusion, neither "Net Operating Income" or "Net Income" are shown anywhere in this software; however, they are used to calculate Debt Coverage Ratios (DCR) and Cap Rate (OAR).

The Debt Coverage Ratio formula is as follows:
Annual Net Operating Income divided by Annual Loan(s) Payment(s) = DCR
Net Operating Income in this context means as calculated by real estate practices. Depreciation and Interest are not deducted from the Adjusted (Effective) Gross Income when calculating the Net Operating Income. In real estate practices, the terms Net Operating Income and Net Income are synonymous, and are different than in accounting practices.
This software uses annual figures, not monthly, so that balloon payments (if any) are figured in.

DCR is used by lenders to determine how likely it is that a property will generate enough net income to make the loan payments (i.e.- Lenders use this ratio as one means to determine if a property is a good risk to loan money on). The minimum ratio the lender requires to make a loan will depend on the lender, the borrower's credit, the type of property, the property's Cash Flow, and the loan terms.

DCR is how many times larger the estimated Net Operating Income is than what the loan payments would be for the same time period.

If you are a lender you know all this. If you are not a lender you should consult a lender regarding the minimum debt ratio they will accept if they are making a loan on a specific property, to a specific borrower, at a specific time.

If there is a 2nd position loan, the 2nd position loan's DCR is best described by the following formula:
(Net Operating Income - 1st Position Loan's Payment) / 2nd Position Loan's Payment = 2nd Position Loan's DCR

For a 3rd position loan the DCR would be as follows:
(Net Operating Income - 1st Position Loan's Payment - 2nd Position Loan's Payment) / 3rd Position Loan's Payment = 3rd Position Loan's DCR

Principal Paid - is called Loan Reduction in this software because it reduces the Balance Owing on the Loan(s).

Loan Reduction
What is the "Loan Reduction" category in the "Total Benefits sheet"? It is a term unique to this software.
In the "Cash Flow" sheet the entire Loan Payment was subtracted from the Scheduled (Effective) Gross Income when calculating Cash Flow . The Principal portion of the Loan Payment is not lost value, so it must be added back to the value stream when calculating the benefits of ownership, simple return, and IRR in the "Total Benefits" sheet.

Therefore, the Principal portion of the Loan Payment is added back to the value stream in the Loan Reduction (aka Principal Paid) column of the "Total Benefits" sheet so that the Annual Benefits Total for each year can be calculated. The Annual Benefits Totals are then used to calculate simple returns and IRR.

Loan Reduction is what RealBenefits calls the Principal portion of the Loan Payment where it is added back into the value stream in the "Total Benefits" sheet.
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Here is another way of looking at Loan Reduction. Look at the "Annual Cash Flow" sheet. The Payment on Loan(s) is deducted from the Adjusted (Effective) Gross Income; the Operating Expenses and Management Fee are also deducted. This results in the Annual Cash Flow (pocketable cash).

Now look at the "Total Benefits" sheet.
The Annual Cash Flow from the "Annual Cash Flow" sheet is entered into the Cash Flow column on the "Total Benefits" sheet. REMEMBER that the Annual Cash Flow figure is cash in the investor's pocket AFTER paying all Loan Payments, Operating Expenses, and Management Fees.

The Principal Paid is not cash the investor can put in his or her pocket, but is not an expense either. It is savings in the form of Equity Increase and must therefore be added back to the value stream when calculating the financial benefits of ownership. The Loan Reduction (aka Principal Paid) column in the "Total Benefits" sheet is where that value is added back to the value stream.

Inflation (how it affects Debt, Appreciation, Cash Flow, and profit)
Inflation benefits a money borrower because it decreases the value of each dollar owed. So while interest works to increase the amount of dollars owed, inflation decreases the value of each dollar owed. The higher inflation is AFTER the borrower has obtained fixed rate financing, the better for the money borrower. In this context, the borrower is the income property owner who borrows money to purchase income property.

Inflation can be bad for money lenders who make fixed rate, fixed payment loans, for the reasons described above. However, this software is written primarily from the point of view of the property owner (who is the borrower) and their agents (real estate, accountants, etc.). Therefore, from that point of view, FUTURE inflation is very helpful to a borrower (property owner/investor) who has PREVIOUSLY obtained a fixed rate, fixed payment loan during a time of LOWER inflation. If the current inflation rate is high, borrowers may find it difficult or impossible to find a low interest fixed rate, fixed payment loan. However, if the borrower (property owner/investor) can obtain fixed rate financing during a period with low interest rates (during low inflation period), then high inflation occurring AFTER that will help the borrower.

Inflation also causes rent/lease income and expenses to increase by a similar percentage, thereby increasing the net income. If the loan has a fixed rate and payment, then it's much easier for the property owner to pay the loan payments after inflation occurs because the net income has increased due to inflation while the Loan Payment stayed the same, which means that Cash Flow increases. Inflation increases Net Income and Cash Flow.

Inflation is one of many causes of property Appreciation, and therefore, Equity Increase. There are also other causes of Appreciation and Equity Increase: supply and demand for location, zoning and therefore local politics, local economy, etc.) (Principal portion of Loan Payments also increases Equity).

The more inflation the better for the property owner, so long as it occurs AFTER they purchased the property and obtained fixed rate financing, and DURING the time they own the property but are not trying to sell it. It is difficult to sell property when inflation is high because buyers have difficulty obtaining attractive financing terms (i.e.- interest rates are high when inflation is high).

A time of high inflation is usually not a good time to buy property because interest rates are high, so therefore it is also a difficult time to sell property. High inflation is a hindrance to buying or selling an income property, but it is great for the property owner if they are not trying to sell at that time AND they previously acquired low interest, fixed rate financing (during a time of lower inflation).

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Note that in this software on the Form sheet line 10 is the Inflation grey data input cell. Enter a reasonable projected future average annual Inflation for the next 10 years. i.e. - enter what you think annual inflation will typically be over the next 10 years. Consult a CPA as needed.

The percentage you enter for Inflation is used to increase the income and expenses each year for 10 years in the software's presentation.

Inflation dollar amounts (in the software's presentation) compound annually based on a 360 day year. A 360 day year is used because that is standard practice in the lending and real estate professions. This is the same principle as a compound interest loan, except that the property owner is receiving it instead of paying it.

Appreciation
The general concept of property appreciation is so simple and basic that everyone reading this probably understands it well enough that there is no need to cover the basics. So I will cover a more advanced area of appreciation. How do you decide what projected future annual Appreciation % to enter in the Form (data input) sheet? Entering a reasonable % is not as simple as you may think. You may know how to do the research, but do you know how to do the calculations CORRECTLY? Please finish reading this before you decide if you know how to do these things correctly.

If you think that deciding on a reasonable, projected, future Annual Appreciation % is as simple as guessing, or as simple as looking at the past history of the subject property and comparable properties and using arithmetic to find the Annual Appreciation % based on past sales, then you do not understand what is involved, so you need to read the rest of this topic.

Your goal should be to enter (in the Form sheet) a reasonable, projected, future average Annual Appreciation for the subject property based on the past average annual appreciation of several comparable properties, and the subject property itself, if it has been bought and sold before.

You can enter your best guess to get a book of projections, but if you want to create professional, accurate projections, then you must do some background research and calculations. The research involves going to the title company or assessor's office (don't rely only on a multiple listing service because at least half of income properties are sold by their owner or by a commercial real estate agent who does not enter income properties in the MLS) with a list of comparable properties and determining the prices each property sold for the last 2 times. Also do this with the subject property if it has been sold at least twice before. If the subject property has not been sold twice before, which is the case with newer properties, then research comparable properties.

The difference between the prices each time a property sold obviously is your total dollars of appreciation.

You also have the time elapsed between the sales.

It may seem like common sense that you could use arithmetic to find the average % annual appreciation (compounded yearly). That would be WRONG and would mistakenly inflate the average annual appreciation. Annual Appreciation compounds each year, which means the property value grows exponentially. That means algebra, logs or roots, not simple arithmetic, must be used. Sure you can use simple arithmetic to go forward in time to determine dollars of appreciation when you are given the percentage, but you CANNOT use arithmetic to find the percentage; you need algebra, or a financial calculator or software that does the algebra for you (i.e.- you can go forward in time with simple arithmetic, but cannot go backward in time, except with algebra, specialty calculator, or software). RealBenefits' Appreciation workbook can solve this for you.

Once you correctly solve the historical (past) average annual appreciation percentage for one comparable property, you should do a few more comparables. Once you have 5 or so comparable properties, you should take the median value. That means take the most common value. For example, if you solved for the (historical, past) appreciation percentage of 5 comparable properties, and you got these percentages:
3%, 5%, 5%, 6%, 10%, you would use 5% as your median historical appreciation for that type of property in that area because we have an odd number of values to choose from, so we just pick the middle value of 5%. If you had an even number of comparables, you would take the two middle values, add them together, and divide by 2.

In this example, when filling out the Form sheet line 10 in this Benefits IPO workbook, you would enter 5% for the (projected future) Appreciation for the subject property (based on your research).

For those wanting to use a financial calculator to find the average annual appreciation percentage compounded yearly, plug the earlier sales price into present value, the later sales price into future value, plug the number of years into the number of periods (3 years is 3 periods, 5 years & 6 months is 5.5 periods, etc). You do not enter anything for payment. Solve for interest (paid at end of each period). If you entered the data correctly, you get the correct answer. However, unless you are very confident, you will have nagging doubts that you pushed the correct buttons, etc.,

I suggest you take the easy way out and use RealBenefits "Appreciation" template. You can find it by going to the menu at the top left of your screen. See "File", "New", "All Types of Real Estate", "New Appreciation Workbook". It will do all the calculations for you. All you have to do is type in 4 input numbers: The price the property sold for each of the last two times it sold, and the dates of each sale. What could be easier? The math is done for you. You don't have to wonder if you hit the correct keys on a calculator because there are no keys.
All you have to worry about is entering 4 input numbers: the 2 sales prices, and the 2 dates of each sale.

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Note that in this software on the Form sheet line 10 is the Appreciation grey data input cell. Enter a reasonable projected future average annual Appreciation for the next 10 years. i.e. - enter what you think annual appreciation will typically be over the next 10 years. Consult a commercial appraiser as needed.

The percentage you enter for Appreciation is used to increase the Property Value and Equity each year for 10 years in the software's presentation. From this is derived the Equity Increase, which is one of the financial benefits of ownership.

Appreciation dollar amounts and therefore Property Value (in the software's presentation) compound annually based on a 360 day year. A 360 day year is used because that is standard practice in the lending and real estate professions. This is the same principle as a compound interest loan, except that the property owner is receiving it instead of paying it.

Equity Build-up - is the same as Equity Increase. This software uses the term "Equity Increase" abbreviated as "Equity Incr."

Equity Increase - is the same as Equity Build-up. This software uses the term "Equity Increase" abbreviated as "Equity Incr."

Equity Increase = Appreciation + Loan Reduction
(Remember that "Loan Reduction" is "Principal Paid")

Also see Return on Equity (far below in Return section)

Depreciation
This is a "Tax Deduction" given to income property owners to compensate for wear & tear on the property structures. For more information see "Tax Deduction" on this sheet. Also, see the notes on the "Form" sheet, see the "Depreciation" sheet, and see the "Total Benefits" sheet's Tax Benefits columns for more information on depreciation and tax matters.

PDIG (Percent Depreciation this Investor Gets)
This is the percent of the depreciation (on the property structures) that this specific investor gets to deduct from their taxes. This is 100% in the most common situation, which is when the loan is a recourse loan and the investor owns 100% of the property. However, in situations where the investor has less than 100% interest in the property (part-ownership), the PDIG will be less than 100%, and may be different for each part-owner in the property (even if they have the same percentage of ownership).

This software auto-calculates the PDIG for you based on your answers to the questions in the "Form" sheet in items 25, 26, 27, and 28 which are: "What is the % ownership being analyzed?", "What type of entity is the property buyer?", "Is the loan recourse or non-recourse?", and "Who is liable for the loan?".

If the investor's CPA wants some other % PDIG entered instead of the % the software auto-calculated, you can manually override and use any % the CPA tells you. However, unless a CPA tells you otherwise, don't worry about the PDIG; just let the software use its auto-calculated PDIG.

To see the "Auto-Calculated PDIG" see line 15 of the "Form" sheet, the white cell with a percentage in it.
To see the "Manually Entered PDIG" see line 15 of the "Form" sheet, the yellow cell. The amount manually entered in the yellow cell (if any) will not override the white cell unless the appropriate drop-down box choice is selected in line 15 of the "Form" sheet!

More detailed PDIG information is located in the "Instruc. Part-Ownership" sheet.

You should ignore the PDIG issue altogether and let the software automatically handle it, unless the investor's CPA wants a different PDIG used than the PDIG showing in the white cell in line 15 of the "Form" sheet.

Tax Write-off - Tax Write-off and Tax Deduction are synonymous. See Tax Deduction below.

Tax Deduction
The dollar amount you can deduct from taxable income. Do not confuse "Tax Deduction" with "Tax Reduction". See Tax Reduction below.

Tax Reduction
Tax Deduction X Tax Bracket = Tax Reduction

Tax Reduction, Tax Savings, and Tax Benefit are synonymous. See definition of "Tax Benefit" below for a full explanation.

Tax Savings
Tax Reduction, Tax Savings, and Tax Benefit are synonymous. See definition of "Tax Benefit" below for a full explanation.

Tax Benefit
Tax Benefits are the Tax Reductions that result from Tax Deductions.

Tax Deduction X Tax Bracket = Tax Reduction aka Tax Benefit

Mathematical Example: $1,000 Tax Deduction X 36% Tax Bracket = $360 Tax Reduction aka Tax Benefit

For example, a $1000 Deduction for a person in the 36% Tax Bracket is a $360 Tax Reduction (aka - a $360 Tax Savings, aka - a $360 Tax Benefit). The person in this example pays $360 less taxes than they otherwise would have. Generally this would be $360 less taxes on the income of the subject property. Whether the $360 Tax Reduction resulting from the $1,000 Deduction can be taken against "other income" (other than that generated by the subject property) if the subject property has a Net Loss (as calculated by accounting principles) is something this software does not address, but the investor's CPA should.

This software is a combination of real estate and accounting practices. One of the real estate practices followed is that "Cash Flow" is segregated for separate analysis in the "Annual Cash Flow" sheet (prior to calculating Total Annual Benefits in the "Total Benefits" sheet). Therefore, certain adjustments must be made in the "Total Benefits" sheet to bring the analysis back in line with accounting principles before calculating the "Total Annual Benefits" column. Once these adjustments have been made, the "Total Annual Benefits" column is calculated and its data (value inflows) and the Total Investment (initial value outflow) are analyzed as an annuity to determine the simple return, IRR and NPV FBO (Net Present Value of future Financial Benefits of Ownership compared to an alternative investment) (NPV FBO also depends on the Discount Rate).

An explanation of each adjustment and the related concepts follows:

When Cash Flow is calculated in the "Annual Cash Flow" sheet the Loan Payment, Op. Expenses, and Management Fee are subtracted from the Adjusted (Effective) Gross Income. This determines Cash Flow, but treats 100% of Principal Paid, as lost value. However, it is not lost value. Principal Paid is savings in the form of Equity Increase ("savings" as in value set aside for future use).

Tax Deduction x Tax Bracket = Tax Reduction (aka Tax Benefit)
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$1,000 Tax Deduction X 36% Tax Bracket = $360 Tax Reduction

In this example, $1,000 Depreciation is a $1,000 Tax Deduction which results in a $360 Tax Reduction.
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The value of the Principal Paid and the value of the Tax Reductions resulting from Depreciation must be added to the value stream when calculating annual benefits in the "Total Benefits" sheet.

The "Loan Reduction" column adds back the value of the Principal Paid (i.e.- adds back the principal portion of the Loan Payments) to the value stream.

The "Tax Benefits" column adds the value of the Tax Reductions that result from Depreciation to the value stream.

What is shown in the "Total Benefits" sheet is the potential Tax Reductions due to Depreciation. The dollar amount of the annual Tax Reduction is called Tax Benefit.

Note: Real estate practice does not deduct Depreciation from Adjusted (Effective) Gross Income when calculating Net Income or Net Loss (accounting practice does).

Note: The terms Net Income and Net Loss used in the following context mean as calculated by accounting practices, not real estate practices. This means that in addition to Operating Expenses, the Depreciation and Interest Expenses are also deducted from the Adjusted (Effective) Gross Income when calculating Net Income or Loss.

Most income properties' Deductions (by accounting practice) result in a Net Loss for the first several years which may potentially be used as a Deduction against the investor's "other income". "Other income" is income other than that generated by the subject property. Examples of "other income" are wages the investor earns from a job, and/or income from another income property. Alternatively, it is possible that a Net Loss may be carried forward and Deducted against the future Net Income of the subject property.

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The investor's CPA will have to determine if any Net Loss during the early years of operation can be Deducted against the investor's "other income" or can be carried forward against the subject property's future Net Income. Likewise, the CPA will also have to determine if Net Profit in the later years of operation will increase the investor's overall personal tax liability. This software does not make these determinations. It assumes that all potential Tax Reductions (Tax Benefits) can be used at the end of each year shown (see the "Tax Benefits" column in the "Total Benefits" sheet) whether to reduce the tax on the subject property's Net Income, other income, or both. The investor's CPA must determine how much of the potential Tax Benefits (Tax Reductions) the investor can actually use, and when the investor can use them. The IRR is calculated based on the assumption that all potential Tax Reductions (Tax Benefits) can be used at the end of each year shown, whether used to reduce tax on the subject property's Net Income, the investor's "other income", or both. All the potential Tax Reductions shown can be used to reduce the tax on the subject property's Net Income when there is a positive or zero Net Income. However, when a Net Loss occurs, some of the Tax Reductions shown cannot be used relative to tax on Net Income that year; but may potentially be used to reduce tax on "other income" that year, or be carried forward to reduce tax on the subject property's future Net Income. Over 10 years, most subject properties have a Net Loss for the first few years, break even around the mid year(s), then have a Net Profit for the last few years. Therefore, the initial Net Losses are usually approximately balanced out by the later Net Profits with regard to overall personal tax liability. In fact, with regard to "tax on other income" and the investor's total tax liability, the initial Net Losses usually outweigh the later Net Profits resulting in a slightly positive time value of money effect with regard to "tax on other income" and overall tax liability issues and IRR. This is because time value of money, and therefore the IRR, gives more importance to earlier events. In other words, once the CPA considers the projected initial Net Losses and the later projected Net Profits of the subject property, and the investor's "tax on other income" ramifications over 10 years into account, the projected IRR is usually a little higher than the software shows, although not materially higher.

This software considers tax on Net Income of the subject property related issues, but ignores tax on "other income" issues in its calculations (i.e.- ignores overall personal tax liability) because:
1) The "tax on other income" issue is usually a wash over 10 years with regard to the subject property's IRR.
2) If not a wash, it usually has a slightly positive, but not material effect on the IRR.
3) Mathematically addressing the investor's "tax on other income" issues (i.e.- the investor's overall personal tax situation beyond the subject property's operation) is beyond the scope of this software and must be addressed by the investor's CPA.
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This software displays all potential Tax Reductions in the "Tax Benefits" column of the "Total Benefits" sheet. The annual Tax Reductions shown result from Depreciation Deductions that can be taken against the subject property's Net Income at the end of each corresponding year. This means the investor can use most of the potential Tax Reductions (Tax Benefits) shown at the end of each corresponding year. However, a small portion of the potential Tax Reductions (Tax Benefits) shown during the first few years of operation are often related to a Net Loss; and must therefore either be used to reduce tax on "other income" that year, or be carried forward to reduce tax on future Net Income (or may not benefit the investor at all, as determined by the investor's CPA).

Generally, for the first several years of operation the investor will be able to use most of the potential Tax Reductions shown at the end of each corresponding year to reduce the tax on the Net Income. This is because most of the related Deductions can be used against the subject property's Net Income at the end of each corresponding year. The investor may be able to use the rest of the Tax Reductions to reduce tax on "other income" that year, or may be able to carry it forward to reduce tax on future Net Income, or may not benefit from it at all. This is because most income properties have a Net Loss for the first few years of operation.

Generally, during the mid and later years of operation the investor will be able to use all of the potential Tax Reductions shown at the end of each corresponding year to reduce the tax on the Net Income. This is because all the Depreciation Deductions can be used against the subject property's Net Income at the end of each corresponding year. This is because most income properties break even during the mid year(s) and have a Net Profit during the later years. Therefore, during the mid and later years, all potential Tax Reductions (aka Tax Benefits) shown can typically be used to reduce the tax on the Net Income at the end of each corresponding year. This means that during the mid and later years the investor can typically benefit from all of the potential Tax Reductions (Tax Benefits) shown.

The investor's CPA must determine how much of the potential Tax Reductions (aka potential Tax Benefits) shown each year the investor can actually use, and when they can be used. See the "Tax Benefits" column in the "Total Benefits" sheet for specific "Tax Benefits" numbers and data.

Gain (see specific Gain topics related to Appreciation and Depreciation below)
Gain is the investor's profit from selling the property at the time of sale, which in this software is at the end of the 10th year. Gain is the Appreciation over the term of ownership less closing costs when the property was purchased plus dollars of Depreciation related Tax Deductions taken over the term of ownership.

When analyzing an investor's partial ownership (less than 100%) in a subject property, the Gain allotted to that investor is determined according to the input data entered for that investor in items 15, 20, 21 and 25 through 28 on the ''Form'' sheet. The allotment IS NOT necessarily a straight line relationship to the investor's % ownership.

Gain due to Appreciation (see the general topic of Gain above)
The increase in property value due to inflation and/or an increased demand for land and/or improved properties less closing costs when the property was purchased.

When analyzing an investor's partial ownership (less than 100%) in a subject property, the Gain due to Appreciation allotted to that investor is determined according to the input data entered for that investor in items 20, 21 and 25 on the ''Form'' sheet. The allotment IS NOT necessarily a straight line relationship to the investor's % ownership.

Gain due to Depreciation (see the general topic of Gain above)
That portion of the investor's overall realized gain (at the time the property is sold) that is due to having taken tax deductions for the Depreciation of the improvements over the time of ownership.

When analyzing an investor's partial ownership (less than 100%) in a subject property, the Gain due to Depreciation allotted to that investor is determined according to the input data entered for that investor in items 15, 20, 21 and 25 through 28 on the ''Form'' sheet. The allotment IS NOT necessarily a straight line relationship to the investor's % ownership.

Capital Gains Tax
Tax paid on the gain from a sale of a capital asset. This is proportional to the investor's dollars of the Gain as explained above.

When analyzing an investor's partial ownership (less than 100%) in a subject property, the Capital Gains Tax allotted to that investor is determined according to the input data entered for that investor in items 15, 20, 21 and 25 through 28 on the ''Form'' sheet. The allotment IS NOT necessarily a straight line relationship to the investor's % ownership.

Capital Gains Tax on portion of Gain due to Appreciation
This capital gains tax rate is 15% at the time this software was designed, which is why 15% is the default value on the "Form" sheet (data input sheet). In the event that the rate changes in the future, you can enter any percentage necessary in the grey data input cell on the "Form" sheet.

At the end of year 10, this software deducts from the investor's financial benefits the taxes due at the time of sale. This is because this software makes all projections based on the hypothetical assumption that the property is sold at the end of the 10th year. Look at the "Total Benefits" sheet in the "Tax Benefits" column. Notice that year 10 has a negative Tax Benefit number.

When analyzing an investor's partial ownership (less than 100%) in a subject property, the Capital Gains Tax on portion of Gain due to Appreciation allotted to that investor is determined according to the input data entered for that investor in items 20, 21 and 25 on the ''Form'' sheet. The allotment IS NOT necessarily a straight line relationship to the investor's % ownership.

Capital Gains Tax on the Recapture of Depreciation
Effective May 7, 1997, the capital gains tax rate on the recapture of depreciation is 25%, which is why 25% is the default value on the "Form" sheet (data input sheet). In the event that the recapture rate changes in the future, you can enter any percentage necessary in the "Recapture of Depreciation" grey data input cell on the "Form" sheet.

At the end of year 10, this software deducts from the investor's financial benefits the taxes due at the time of sale. This is because this software makes all projections based on the hypothetical assumption that the property is sold at the end of the 10th year. Look at the "Total Benefits" sheet in the "Tax Benefits" column. Notice that year 10 has a negative Tax Benefit number.

When analyzing an investor's partial ownership (less than 100%) in a subject property, the Capital Gains Tax on the Recapture of Depreciation allotted to that investor is determined according to the input data entered for that investor in items 15, 20, 21 and 25 through 28 on the ''Form'' sheet. The allotment IS NOT necessarily a straight line relationship to the investor's % ownership.

ROI (Return on Investment)
Do not confuse ROI with Return. Return is simple return as explained in the next section below. ROI is an accounting term, not a real estate term. People with accounting backgrounds use ROI to describe the performance of an investment. When ROI is used to describe real estate investments, this causes confusion. Do not use ROI to describe real estate investments. Use Cap Rate instead of ROI. Cap Rate and ROI are the same number once you consider the differences between accounting practices and real estate practices. Operating Income in accounting practices is the same number as Net Operating Income in real estate practices. Therefore, Cap Rate and ROI are the same number and are synonymous. Cap Rate is the correct term to use for real estate investments because Cap Rate is a real estate industry term. Cap Rate is part of Standard Real Estate Practices (SREP). You should not use the term ROI in a real estate context. For more information, see the "Cap Rate" and "Net Operating Income" sections of this encyclopedia.

Return (Simple Return) (also see IRR below)
In Standard Real Estate Practice (SREP), the Return calculation is based on initial equity (i.e. - Downpayment).

In Generally Accepted Accounting Principles (GAAP), the Return calculation is based on the total value outflow required to purchase the property (i.e.- annuity). The total value outflow required to purchase the property is called the Investment. In this software, Return calculations are based on the Investment, which is the Downpayment + Closing Costs + Exceptional Closing Costs + Loan Points.

Exceptional Closing Costs are repairs or anything else needed to close the sale. A typical example is a when a new roof is required to close the sale.

This method of calculating Return complies with GAAP and shows slightly lower returns than the SREP method because the Closing Costs, Exceptional Closing Costs, and Loan Points are included in the Investment. This is a more accurate, thorough, and honest way to calculate Return(s) than the SREP method. This GAAP compliant method gives lower Returns due to using a larger Investment number.

What follows is an explanation of how Return is handled in this software.

Return is the percent of the Investment the investor gets back during a given time period. For example, the Return for the 1st year is how much of the Investment (Downpayment + Closing Costs + Exceptional Closing Costs + Loan Points) the investor gets back the 1st year. The monthly Loan Payments are not counted as part of the Investment because this is not money out of the investor's pocket since the money for the monthly payment comes out of the income received each month. Furthermore, the investor gets to write-off the interest part of each loan payment, and the principal part is savings in the form of Equity Build-up.

So the Year 1 Return on Investment is the 1st Year's Total Benefits divided by Investment (Downpayment + Closing Costs + Exceptional Closing Costs + Loan Points). The Year 5 Return on Investment is the 5th Year's Total Benefits divided by Investment. And so on for each year if you want the return for a specific year. You can calculate the projected return for any time period of ownership. This software only calculates years 1, 5, & 9.

The Return for years 1-10 is referred to in this software as "Years 1-10 Cumulative Return". This is the Total Benefits of Years 1 through 10 divided by Investment. The Total Benefits for years 1-10 is first found by taking the "Total Benefits for Year 1" and adding to the "Total Benefits for Year 2" and so on until each year's Benefits for all years 1-10 are summed. That sum is the Total Benefits of years 1-10 which is the 10 years' Cumulative Benefits as seen on the "Total Benefits" sheets in the "Cumulative Benefits" column.

This software calculates the projected Return for each year, and the cumulative Return for years 1-10. This is Simple Return; it does not take into account the time value of money (IRR does).

Return on Equity [also see Return aka Simple Return (above) and Equity Increase (far above)]
Return on Equity is the Simple Return on Equity each year.

% Return on Equity is the Annual Benefits Total divided by the annual Equity. When the Annual % Return on Equity becomes too low, that means it's time to sell.

Too low is a subjective thing, but can be roughly described as follows:
When your Return on Equity is substantially lower than it would be if you invested in another project, it's time to sell and invest in the other project. For certain it's time to sell when your Return on Equity becomes negative. The % Return on Equity shown here is calculated using the Annual Benefits Total from the "Total Benefits" sheet. That is Standard Real Estate Practice. If the Annual Benefits Total on the "Total Benefits W-O-T-B" sheet (Total Benefits without Tax Benefits sheet) were used, the % Return on Equity would be slightly lower.

IRR (Internal Rate of Return) (also see Return aka Simple Return above)
The IRR is a type of return that does take into account the time value of money. When an investor invests money in a property, he or she does so all at once in the beginning, but the benefits of ownership are received in increments over time. The invested money is tied up in the property and cannot be used for other purposes, or draw interest in a bank account. Therefore, the time value of money is a factor that should be considered when figuring an investor's return. IRR is a type of return that does consider the time value of money, including its effect on the money tied up in the investment, as well as considering the time over which benefits are received.

IRR is the most important indicator of a property's long-term investment performance. This software projects the IRR over 10 years. A projected IRR suggests what the long-term investment performance may be for the investor. However, an investor will not survive long enough to benefit from long-term ownership (i.e.- IRR) unless the Cash Flow is good enough to make it possible to pay expenses and loan payments.

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IRR is substantially higher and more accurate when calculated according to GAAP than when calculated according to SREP. This is because GAAP takes into account all the potential benefits of owning income property, including all the potential Tax Benefits. SREP ignores most of the potential Tax Benefits. The "Total Benefits" sheet follows GAAP. The "Total Benefits W-DP-T-B" follows SREP. See these two sheets and compare their Tax Benefits, IRRs, and NPV FBOs.

Before calculating IRR according to SREP or GAAP, you can and should make hypothetical adjustments to the Property Price to compensate for differences in Property Condition, but most people forget to do this.

The IRR in the "Total Benefits" sheet is typically almost twice as high as the IRR in the
"Total Benefits W-DP-T-B" sheet. This is because the "Total Benefits" sheet follows GAAP with regard to Tax Benefits which results in considering all expenses, including Depreciation and Interest, as Tax Deductions which result in Tax Reductions (related to tax on the subject property's income). The "Total Benefits W-DP-T-B" sheet follows SREP with regard to Tax Benefits which results in considering Depreciation as the only expense Deduction which results in a Tax Reduction. Therefore, the "Total Benefits" sheet shows all potential Tax Benefits (aka Tax Reductions) while the "Total Benefits W-DP-T-B" sheet shows only the Tax Benefits (aka Tax Reductions) resulting from Depreciation. The result is that the IRR shown in the "Total Benefits" sheet is much higher.
It is also more accurate since the IRS follows GAAP, not SREP.

When filling out a listing form or other sales data for the subject property, use the IRR shown in the "Total Benefits W-DP-T-B" sheet because it conforms to SREP and therefore allows comparisons between the subject property and other properties which are for sale. This makes your listing data credible because it is based on SREP like the other agents/sellers property listing data so your projected IRR is similar to the IRR of the other properties that are for sale.

When you meet with the buyer or their agent, use both IRRs. Explain that the IRR shown in the "Total Benefits W-DP-T-B" sheet is calculated according to SREP and you use it because it conforms to SREP. Also explain that the IRR shown in the "Total Benefits" sheet is higher and more accurate because it is calculated according to GAAP. Send them to their CPA with all 3 Benefits sheets and all the other presentation (i.e.- output) sheets. This means print all the sheets to the right of the "Form" sheet and give these sheets to the investor to bring to their CPA (after you explain them of course).

Alternative Investment [also see Discount Rate (below)]
An Alternative Investment is any investment other than the Subject Property. The Alternative Investment can be a real estate investment or a non-real estate investment, such as stocks or bonds. The IRR of the best available Alternative Investment is the Discount Rate of the Subject Property. The Discount Rate is used to determine the Opportunity Cost of investing in the Subject Property instead of the Alternative Investment.

Discount Rate [also see IRR and Alternative Investment (above) and NPV FBO (below)]
The term "IRR" means the IRR of the subject property. The term "Discount Rate" means the IRR of an alternative investment (other than the subject property).

The term "alternative investment" means the investor could invest there instead of the subject property.

The term "investment money" refers to the money used for Down + Closing Costs + Exceptional Closing Costs + Loan Points if the investor invests in the subject property.

The Discount Rate is the % IRR the investor could be making in an alternative investment with their investment money if they do not invest in the subject property. 9% or 10% are common; however, this varies per investor. 9% is this software's default. To be a useful number, you should enter a Discount Rate that represents another investment opportunity that has a similar level of risk, which is a judgment call you have to make.
See NPV FBO below.

PV FBO (Present Value of the future Financial Benefits of Ownership)
See Discount Rate (above) and NPV FBO (below).

NPV FBO (Net Present Value of the future Financial Benefits of Ownership)
Before reading about NPV FBO, you first need to read about Alternative Investment, Discount Rate, and PV FBO above.

PV FBO - Investment = NPV FBO

NPV FBO means the Net Present Value of the future Financial Benefits of Ownership. Enter a Discount Rate in the "Form" sheet which represents the % IRR the investor could make on their investment money if they invested in the best alternative investment that offers a similar level of risk. This software calculates the PV FBO of the subject property reduced by the Opportunity Cost of not having invested in the alternative investment. It then reduces the PV FBO by the Investment dollars (Downpayment + Closing Costs + Exceptional Closing Costs + Loan Points) needed to purchase the subject property.
PV FBO - Investment = NPV FBO

The Opportunity Cost of not having invested in the alternative investment is deducted in the calculation. The Opportunity Cost is based on the Discount Rate you enter in the "Form" sheet. Opportunity Cost is the potential PV FBO (Present Value of the future Financial Benefits of Ownership) of the alternative investment. I.e.- Opportunity Cost is the PV FBO that could be attained by investing in the alternative investment instead of the subject property. The Investment (Down + Closing Costs + Exceptional Closing Costs + Loan Points) is also deducted when calculating the NPV FBO of the subject property.
PV FBO (of subject property) - Investment (in subject property) = NPV FBO (of subject property)

The terms "investment money", "Investment", and "total investment" mean the money used for the Down + Closing Costs + Exceptional Closing Costs + Loan Points if the investor buys the subject property, or that same money invested elsewhere in an alternative investment. The purpose of entering a Discount Rate is to figure out the Opportunity Cost of not having invested in the best available alternative investment so that Opportunity Cost can be deducted when calculating the NPV FBO of the subject property.

FYI - If you enter a Discount Rate equal to the subject property's IRR, the NPV FBO equals zero dollars because investing in the subject property is no better or worse than investing in that alternative investment.

If the NPV FBO is greater than the Investment (Down + Closing Costs + Exceptional Closing Costs + Loan Points), then the NPV FBO indicates that the subject property is that many dollars better an investment than the alternative investment. For Discount Rate to be a reasonable number it needs to be in regard to an alternative investment that has a similar level of risk. The alternative investment that the Discount Rate is based on does not have to be real estate. It can be stock, bonds, or anything else.

Discount Rate is specific to each investor according to the best alternative investment available to that investor.
Therefore, the subject property can be a good investment for one investor, but not for another.

Appraisers and listing agents generally do not need to concern themselves with NPV FBO (although they do other types of NPV calculations not covered by this software). This is because when appraising or listing an income property, the Discount Rate, Tax Bracket, and other investor specific input data items should be left at the defaults which are intended to represent the "typical" investor.

Selling agents should be concerned about the NPV FBO because it can show a specific buyer why the property is a better investment than an alternative investment. NPV FBO and IRR can make comparisons to alternative investments that are real estate or non-real estate, such as stock. Selling agents can input the investor specific data (Tax Bracket, Discount Rate, etc.) because they know who the Buyer is, and therefore can obtain the investor specific data.

Lenders should be concerned about the Discount Rate, NPV FBO, and other investor specific data because if the subject property is not a good investment for the investor, the investor will be less motivated to make their payments. This is because if they can make more money elsewhere than by owning the subject property it would be more profitable for the investor to let the payments lapse and let the lender have the property back. Even if the investor is not aware of this at the time they purchase the subject property, they may become aware of it at a later time. Therefore, it is in the lender's best interest to make a loan to help the investor purchase the best investment for that investor.

See Discount Rate above.

Cash Flow
Cash Flow is how much money is left each month after paying Expenses (not counting depreciation), Management Fee (if any), and the Loan Payment. Cash Flow is the best indicator of short-term success (i.e.- survival) for an investor. A healthy Cash Flow is essential for the investor to survive long enough to gain the long-term benefits of ownership indicated by IRR. The Cash Flow for the first few years is crucial for the investor to survive. After the first few years, Cash Flow is usually much better due to rent or lease increases while the Loan Payment is fixed and does not increase over time. This improvement in Cash Flow relies on having a fixed Loan Payment and increasing rents over time due to Inflation and/or Appreciation. However, even a variable rate loan generally allows better Cash Flow as time goes by because the rents will eventually increase beyond potential payment increases; but in the early years of an income property investment, before rents have risen much, a variable rate loan can be risky and stressful for the investor.

Exceptional Closing Costs
All non-financed repairs or improvements which are to be made before, soon after, or within one year of closing and are to be paid for by the buyer; or are a hypothetical means of adjusting a subject property to a hypothetical state of equality with a comparable property. Type the "Exceptional Closing Cost" amount in the "Form" sheet in the grey cell of line 22.

Exceptional Closing Costs are paid before, at, or soon after closing by the buyer.
If the repair is to be financed, it is not an Exceptional Closing Cost, but instead should be added to both the Property Price and the Loan Amount (i.e. - not to the Closing Costs since it is financed).

Reserves (aka Replacement Reserves put into a "Reserves Account", i.e.- savings account)

If you want to follow Generally Accepted Accounting Principles (GAAP):

DO NOT include Reserves (if any) in the "Mo. Operating Expense" amount you enter in the grey cell in line 8 of the "Form" sheet because this would invalidate the Cash Flow, IRR, NPV FBO, and Cap Rate (OAR).

This means DO NOT treat Reserves as an expense because "Reserves money" is NOT spent when the Reserves are set aside. It is put into savings and earns interest until the repair is needed; it does not become an expense until the repair is made. Therefore, DO NOT enter Reserves anywhere in this software, even if this property will have Reserves.

Cash Flow, IRR, NPV FBO, and Cap Rate (OAR) will not be affected because you DO NOT treat Reserves as an expense.

If you want to follow Standard Real Estate Practice (SREP)

DO include Reserves (if any) in the "Mo. Operating Expense" amount you enter in the grey cell in line 8 of the "Form" sheet because this treats Reserves as a Monthly Expense, which is what you want. DO NOT enter Reserves anywhere else in this software.

This means DO treat Reserves as an expense because "Reserves money" is NO LONGER AVAILABLE TO THE INVESTOR once it is put into a "Reserves Account". It is put into savings and earns interest until the repair is needed; because it is not available to the investor it is treated as an expense even though the repair has not yet been made.

Cash Flow, IRR, NPV FBO, and Cap Rate (OAR) will be lower because you treat Reserves as an expense.

If you want to be as mathematically accurate as possible: (author's opinion)

The most mathematically accurate method is to treat the monthly Reserves amount as a Monthly Expense because it is money no longer available to the investor, but ALSO figure the monthly interest earned on the "Reserves money" in the savings account, and add that interest to the Monthly Income.

This method is the software author's opinion, and does not follow either standard accounting or real estate practice, but is more mathematically accurate with regard to Cash Flow, IRR, NPV FBO, and Cap Rate (OAR).

Which of the 3 reserves methods above should you use?
Use either the Standard Accounting Practice (GAAP) or the Standard Real Estate Practice (SREP) method, according to which conforms to the standard practices of your profession. If you are representing yourself, you can use whichever of the 3 methods best suits your need(s).

If you are creating presentations for someone else, you should consider using the method they use, or at least find out the method they use so you can communicate without misunderstandings.

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Real Life Effects of Reserves
In reality, "Reserves money" is tied up far in advance of the repair(s) being needed, which is usually not good for the investor since they probably can invest that money where it earns more than the interest from a savings account. Also, Cash Flow is reduced whether or not you choose to show that in projections (i.e.- whether you choose to count Reserves as an expense or not). Consequently, Reserves reduce Cash Flow, Return (simple), IRR, and NPV FBO.

On the other hand, a "Reserves Account" does offer some assurance of being able to make future repairs. So there is a safety benefit here.

Sometimes lenders, insurance companies, or a seller selling on contract (seller financing) may require a reserves account for future repairs. This protects the lender and/or insurance company by assuring repairs can be made when needed. The lender and/or insurance company does not care how this affects the property owner's return. 
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